Barton (2001) studied managers’ use of derivatives and discretionary accruals to smooth reported earnings. As Barton points out, both of these devices have smoothing potential—

since earnings can be expressed as the sum of operating cash flows and total accruals, smoothing can be accomplished through operating cash flows (which can be hedged by derivatives—a real earnings management device) and/or through accruals (by means of the discretionary portion).

From a sample of large U.S. firms during 1994-1996, inclusive, Barton found that managers trade off the use of derivatives and discretionary accruals in order to maintain (i.e., smooth) earnings volatility at a desired level. Specifically, firms that were heavy derivatives users tended to be low users of discretionary accruals, and vice versa. Other things equal, this suggests that managers are sensitive to the costs of smoothing earnings. That is, firms appear to use the combination of smoothing devices that are, for them, the least costly.
Required

a. Give reasons why managers may want to smooth earnings.

b. What are some of the costs of opportunistic smoothing of earnings? Why would managers trade off these two earnings smoothing devices, rather than using only one or the other?

c. Are Barton's results more consistent with the opportunistic or efficient contracting version of positive accounting theory? Why?